Credit Default Swaps; the next and final world economy back breaker

Credit Default Swaps; the next and final world economy back breaker

www.time.com

“Former staff member of the Commodity Futures Trading Commission, Michael Greenberger describes a credit swap in brief: "A credit default swap is a contract between two people, one of whom is giving insurance to the other that he will be paid in the event that a financial institution, or a financial instrument, fails. It is an insurance contract, but they've been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a 'swap,' which by virtue of federal law is deregulated."

(visit the link for the full news article)

Although this issue has yet to hit the main stream media, I anticipate that it will hit in a big way. Due to the complexity of the financial house of cards, the anatomy of this potential catastrophe will be hard to explain on the 6 o'clock news:

A credit default swap (CDS) is a credit derivative (owed debt) agreement between two parties. The "buyer" makes payments to the "seller" in installments in exchange for the right to a payoff if there is a default or a down turn in respect of a third party referred to as the "reference entity".

This system of offsetting the risks is employed when a seller or supplier loans money or materials to an institution or manufacturer. If the institution or manufacturer defaults then the seller will call in the debt from the buyer of the CDS. It is an insurance policy of a kind but it is not referred to as such since to call it insurance would mean that this trading would fall under legislative regulations. In effect, CDS trading is a free for all with pension fund holders, corporations, etc, speculate in this for immense profits.

Since there are no regulations controlling this secretive trading, there are no guarantees that buyers have the income to cover losses. Lessons learned from the Great Depression of the 1920 have taught us that trading on margin propelled the world to an economic catastrophe; debts that were called in went unpaid when the stock market crashed. Today we have the credit crunch with banks and finance houses either hording cash or sinking with the burden of subprime loans. All these loans and lack of liquidity in the financial world means that it is only a matter of time that CDS buyers are called on to cover losses.

The extent of this trade, credit default swaps, effectively parallels the actual trading of shares, resources, products and financials goods. It is comfortably believed that there is several hundred trillion dollars of these swaps in circulation and the distinct possibility of what is known as a “death spiral”. A death spiral entails the stampede of buyers defaulting on their agreement, once reference entities fail to perform across the board with the current economic decline. We already see this psychology entrenched within banks who are hoarding cash.

With the serious down turn in the performance in the futures market and the loss of liquidity in national economies, more and more institutions are offsetting their risks as we speak.

www.reuters.com...



Newsweek article on CDS dated September 27th

www.newsweek.com...

Hedge fund firms traditionally traded in the space were exchange rates and commodities fluctuated. With increased sophistication of the CDS market, they moved into the more complex speculation on defaults by buying a new kind of instrument of insurance by spreading the risk of a debt they had no exposure to but sought to profit from the collapse of banks and corporations through “short-selling”. This is the ‘greed’ that Prime Minister Gordon Brown reacted to and he has set in motion of banning short-selling in the UK.

www.iii.co.uk...

Short-selling shares could soon be permanently banned in the UK, Gordon Brown has said.

The prime minister told the BBC Radio 4's Today programme that it was wrong that "good companies" could be brought down by "speculative activities" in the financial markets.
"Short-selling is something that has existed in the markets for years, but when groups of people are exploiting a difficult economic situation...it is right to stop the short-selling," he said. "We'll be reviewing over the next four months and I'll think you find new rules come in for the future."

The bottom line is that we are really at the precipice and a major economic event will set off the cascade of CDS defaults leaving the world financial markets with a several hundred trillion dollar black-hole.





www.time.com
(visit the link for the full news article)

Originally posted by masonwatcher
Although this issue has yet to hit the main stream media, I anticipate that it will hit in a big way.

As this is a Time article from 8 months ago, I'd say it's plenty in the mainstream media.

Originally posted by anachryon

Originally posted by masonwatcher
Although this issue has yet to hit the main stream media, I anticipate that it will hit in a big way.

As this is a Time article from 8 months ago, I'd say it's plenty in the mainstream media.

CDS has always been discussed in the news journals, but not the collapse of this unregulated market. A number of things are a concern, elements within this market proactively undermined the jittery financial economies by short-selling and creating an environment for CDS defaults as recession sets in or a major incident occurs, the amount of money behind CDSs is unknown, and there is the prospect of a death spiral of defaults.

Basically a Credit default swap was insurance without the need for the party insuring to have cash reserves to back up the swap like real insurance has to have by regulation.

For Example a life insurance company has 1 billion dollars or insurance inforce with their policy owners, should all of them die at the same time, they can pay out the 1 Billion since they by law had to keep cash reserves available to cover it.

Credit default swaps were a different beast. If they had 1 Billion dollars of swaps out on "insuring against" the mortgages going bad underlying some of these real estate securities, they didn't have to have 1 Billion dollars in cash available. In fact they didn't have to have any real amounts of cash available for these Swaps. So when the Mortgages started going bad, the swaps had to pony up and they had nothing there .

The Kicker was that the same brokerage houses and Banks sold not only the Risky Real Estate Securities, they also sold the same customers the "Protection" of the Credit Default Swaps, which were in fact worthless if the whole thing started to unravel, which it has. Truly despicable behavior, selling these risky securities as safe vehicles with the "protection" of the Swaps to cement the deal with unsuspecting investors. The Bad mortgages were only the tip of the iceberg all the side bets brokerages made with the derivatives and swaps are the 90% below the surface.

Remember only about 5 to 7% of mortgages have failed. We could have paid off all of them and still have been allright, its the sides bets that have basically doomed us.

[edit on 25-10-2008 by pavil]

Originally posted by pavil

Remember only about 5 to 7% of mortgages have failed. We could have paid off all of them and still have been allright, its the sides bets that have basically doomed us.

[edit on 25-10-2008 by pavil]

And this is what people dont want to talk about is this right here. The fact is the mortgage failures with all the money thrown at this could of been paid of several times over. The problems are coming from the other bets that were made by these guys using money they didnt have. Some of these banks were leveraged 40 to 1. Now they have lost this money in different bets and have not got the money. This is why you are seeing deflation right now. So the printing presses are on to combat this in the short term but the long term....that could be another story.

reply to post by pavil

Remember only about 5 to 7% of mortgages have failed. We could have paid off all of them and still have been allright, its the sides bets that have basically doomed us.

Precisely. You said it better than I did. We are on the verge. Let's see if these technocrats (Bush not included) who call themselves our leaders can stop this disaster.